By Eric J. Fry
Pension plans are selling stocks. Headline or footnote?
Recent history suggests this little news item should be a headline. Pension plans – like supertankers, but unlike politicians – take a lot of time to reverse direction. But once plan fiduciaries decide to proceed in a given direction – investment-wise – they typically continue down that path for years, if not decades.
This tendency provides the mother of all long-term indicators for the financial markets. Although pension plan fiduciaries tend to be VERY wrong at major, long-term turning points, they tend to be right – more or less – as markets transition from one extreme to the other.
The principal is actually very simple: pension plans behave like long-term momentum investors. So they tend to buy into rising markets…until after those markets have peaked and begun a major decline. Conversely, fiduciaries tend to sell into falling markets until after those markets have bottomed out and begun a decisive uptrend.
In aggregate, therefore, pension fund fiduciaries tend to behave like novice investors – buying high and selling low. But since their momentum investing unfolds over such long timeframes, this group of investors tends to be very right during the middle of a big move – up or down – in any particular asset class.
The world’s fourth largest pension provides a classic case in point. The California Public Employees’ System (CalPERS) with $181 billion of assets at last count, ranks fourth on the list of the world’s largest pensions plans. But it might rank first on the list of worst market-timers. Between 1983 and 2000 the pension giant doubled its allocation to equities…just in time for one of the stock market’s worst decades ever.
During the middle of this giant bull market, CalPERS was correct to up its allocation to stocks. But by continuously upping its exposure to a rising stock market, CalPERS eventually overdid it.
In September of 2000, as the U.S. stock market was beginning its colossal collapse from the then-record highs set earlier that year, your editor highlighted the vulnerability of CalPERS’ stock-heavy portfolio. In an article entitled “Golden State Bulls,” he observed, “In 1983, with a moribund Dow Jones Industrial Average hovering around 1,200, the powers that be [at CalPERS] deemed 30% to be the optimal equity weighting for the fund. But 17 years and 10,000 Dow point later, the CalPERs…investment committee now allocates a whopping 67% of assets to equity investments.
“Meanwhile,” the article continued, “the fixed-income allocation has atrophied to but a shadow of its former self: from 67% back in 1983 to little more than 28% [today]…That’s been a swell situation for the last few years. CalPERs – ominously referred to as the ‘The System’ in the fund’s literature – earned a 10.5% return on its investments for the year ending June 30, 2000, marking the sixth straight year of double-digit returns.”
Despite these pleasing investment results from the recent past, your editor wondered aloud about the immediate future: “If the bull market of a lifetime commenced when CalPERS was wading only ankle- deep in equities (some 30%), what does it mean that the pension giant now fairly bathes in them?”
Investors did not have to wait long for the answer: The stock market stunk up the place for the next nine years. Your editor highlighted this exact risk in his article.
“A back-of-the-envelope calculation shows that if the equity component [of the CalPERS portfolio] were to merely break even [during the next six years],” he warned, “the balance of the portfolio would need to generate a 25% return to meet the [fund’s] actuarial assumption. And you know, that may not happen every year.”
CalPERS did not welcome your editor’s pro bono investment advice. In an October 8, 2000, story in the Sacramento Bee, CalPERS spokeswoman, Patricia Macht, countered, “That’s (the magazine’s) back-of-the-envelope calculation. We don’t manage people’s money on back-of-the-envelope calculations…We’re not in stocks because we make a lot of money, we’re in at the level that’s prudent to be.”
Your editor, defending his criticism in that same Sacramento Bee story, replied, “Just because [CalPERS’ equity-heavy allocation] has worked doesn’t mean that it’s responsible.”
CalPERS would have none of this criticism…and neither would any of the giant pension’s many defenders and apologists. An influential money manager, who’s name your editor will mercifully withhold, ended the Sacramento Bee by scorning your editor’s concerns as “dead wrong.”
As it turns out, of course, your editor’s concerns were “dead right.” (The S&P 500 Index has produced a total return of minus 12% from the end of September 2000 to the present). But anybody can get lucky once or twice.
More to the point, CalPERS “knew better”…or it should have. It should have known that stocks sometimes go down. So it should have also known that a fund that must dispense billions of dollars every year to retirees cannot prudently allocate 70% of its portfolio to such a volatile asset class. But the investment mavens at CalPERS could not bring themselves to worry about worst-case scenarios while best-case scenarios were delivering such delightful returns.
And besides, the stewards of the giant pension fund certainly understood that – come what may – they could always cite chapter and verse of the long-term bull case for equities. They could simply remind their would-be critics that equities had outperformed bonds by a large margin over almost any timeframe during the preceding 100 years. Between 1900 and 1999, for example, U.S. stocks gained an average of 12.9 percent a year, while bonds returned only 4.7 percent annually, according to the data from the London Business School and Credit Suisse. Armed with such rear-looking data, and lots of pretty charts, the CalPERS pension fund charged into the new century loaded for bull.
This equity-heavy allocation seemed unassailably prudent to the stewards of CalPERS, who rarely missed an opportunity to congratulate themselves for a job well done. Not content to merely draw a paycheck, without also drawing attention to himself, Michael Flaherman, then-chairman of the CalPERs investment committee, crowed in mid-2000, “Our performance is the culmination of superior investment and risk management.”
No sooner had Flaherman slapped himself high-fives than the stock market Fates began conspiring to punish his unabashed hubris. Since the end of the last millennium, stocks have produced an average annualized loss of 2.3 percent, compared to an annual gain of about 6.3 percent for bonds. Not surprisingly, therefore, CalPERS’ equity- heavy fund has generated a meager 2.2% average annualized (gross) return since 1999. (For some mysterious reason, CalPERS discontinued reporting its investment returns net-of-fees in 2002. All of which means that the stated return of 2.2% would actually be a much smaller number).
But now that the bear market pony has frolicking outside the barn for several years, the CalPERS investment team is slamming the barn door shut. The team is drastically reducing its allocation to equities. As of last June, CalPERS reduced its equity target from 56% to 49% – the lowest such allocation since 1993. (Including “alternative” equity assets like hedge funds, the revised equity target would be 61.4%, down from 66%).
Net-net, CalPERS is now a seller of equities…or at least not a buyer. Most of the other pension plans in the U.S. (and in the rest of the world) will likely follow CalPERS’ lead.
“Equity assets in the U.K. fell to 41 percent of holdings at the end of 2008, according to data compiled by New York-based Citigroup,” Bloomberg News reports. “The last time British pension funds held so little in equities was in 1974…”
Meanwhile, Bloomberg continues, “Four of the world’s seven largest pension funds…have cut their equity target allocations…” It’s probably safe to assume, therefore, that “caution” is the new buzzword in the halls of most pension fund managers. So it seems highly unlikely that they will exhibit their former exuberance for equities any time soon.
Demographic trends, as well as caution, will prohibit aggressive equity allocations. In California, for example, the baby boomer retirement wave is just beginning, which means that CalPERS must begin favoring capital preservation over “long-term growth.” Ditto most other pension funds on the planet.
“The number of people worldwide 65 and older may jump to 1.3 billion by 2040 from 506 million last year,” Bloomberg reports. “Their proportion of the total population will double to 14 percent in the same period, according to a June report from the U.S. Census Bureau.”
“[Since] the heavy equity weightings of public pension funds in this great land of ours comprise not only the mother of all sentiment indicators, but also a monstrous overhang of stocks, what if the funds sell?” your editor wondered in his mid-2000 article. “No sane fiduciary would choose to sell stocks of course – not if he or she wished to retain a comfortably feathered nest. But demographic trend may force the hand…Probably, the looming overhang is nothing to worry about – right now. But when the overhang threatens to break loose, remember: you heard it hear first.”
That moment may have arrived.
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